Misconceptions on Chinas Role in Financing the US Deficit

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The most pressing issue in Sino-American relations right now is that the relationship is misunderstood by both sides. Moreover, the misunderstanding may be sharpening.

On the Chinese side, there seems an increasing belief that China is now more important to the U.S. than the U.S. is to China. This is dangerously untrue. On the American side, there is increasing tendency to point fingers at China to avoid our own failures. This will only make matters worse. The misconceptions are many, but perhaps the most important involve the colossal U.S. budget deficit and China's role in financing it, the peg of the yuan to the dollar, and the simplistic notion of mutual Sino-American interdependence.

The U.S. and China are interdependent, but China needs the U.S. far more. On the American side, China is the best supplier of many goods, but other low-cost suppliers -- such as Vietnam -- are waiting. Without China, prices in the U.S. would be higher, but not much.

On the Chinese side, there is a concrete element of dependence and an abstract element. In 2008, exports to the U.S. generated 7.4% of Chinese gross domestic product. There is no equivalently large number for China contributing directly to American GDP.

But the more important dependence is abstract. The world trading and financial system was created by and is still led by the U.S. American leadership has drawbacks as well as advantages but it exists, regardless.

China continues to benefit immensely from this system. Each year, China brings in hundreds of billions of dollars in net gains from trade, which would not be possible without open international trade. China produces more than it consumes across a wide range of sectors. Without an export outlet, oversupply would cause crushing deflation and cripple genuine growth.

Open trade is sustained by American willingness to buy, not just from China but also Japan, Germany, and others. If America turned protectionist, there would be little reason for these countries to support free trade, and China would find all its export markets closing.

China depends similarly on the American-led financial system. There are many justified complaints about U.S. financial policies. Nonetheless, China tightened the link of the yuan to the dollar before the crisis and has held that extremely tight link throughout. The notions that the U.S. depends more on China or they are equally dependent are immediately put to rest by the yuan peg: A stronger economy never binds itself to a weaker economy's currency.

The exchange rate clarifies economic relations between China and the U.S. but also has the potential to poison it. Many Americans, including members of Congress and the Obama administration, appear to believe the yuan peg is the biggest problem in the world economy. It is a problem, but it is far from the biggest.

In economics, flexibility brings efficiency and wealth, and rigidity brings inefficiency and distortion. When the production and price relationships in two economies change, the exchange rate of their currencies should also change; otherwise, harmful imbalances will result. Because the U.S. and China have the largest economies, distortions in their relations strongly affect the world.

But the yuan peg is not the most important Chinese policy. Instead, massive support given to state firms is the most important, and most harmful. On behalf of state firms, China raises prices by creating regulated monopolies, gives away land that should belong to citizens, and offers nearly free capital via bank lending that comes ultimately from household savings. This protection on behalf of state enterprises utterly dwarfs in size the recent, unfortunate duties imposed by the U.S. on some Chinese products.

In addition, a yuan appreciation will not have the impact many expect. From July 2005 to June 2008, the yuan rose 20% against the dollar. Yet China's annualized trade surplus with the U.S. rose by nearly 50%.

This occurred mainly because actions by the American government excessively stimulated consumer demand, including demand for Chinese goods. Extremely ill-advised budget deficits and durably low interest rates in that period did far more damage to the U.S. economy than the yuan peg.

Some might argue all of this is secondary to the fact that the U.S. is greatly in debt to China. It turns out the debt is exaggerated.

The American government posted a deficit of $1.4 trillion in 2009 and anticipates a deficit of $1.6 trillion in 2010. These are a terrible burden on the U.S. economy and encourage harsh questions about U.S. leadership. The U.S. sells bonds to finance its spending, and the [Chinese] State Administration of Foreign Exchange (SAFE) is one of the buyers.

The true amount of American government bonds SAFE holds is unknown because SAFE offices in other countries, such as Britain, can buy bonds but are not counted as Chinese, and because the U.S. does not regularly publish data on all types of bonds. It does publish regular data on Treasury bonds and here China's official holdings are an impressive $800 billion (China has at least $500 billion more in other types of holdings).

Nonetheless, the very size of American deficits means this is not an especially important amount. On official data, China holdings of U.S. Treasury bonds are less than 7% of the total. China financed barely 5% of the huge U.S. deficit in 2009, yet American interest rates fell slightly. Huge American deficits are terrible policy and should stop. But the U.S. can continue them without China.

Finally, there are China's foreign reserves themselves. From 1980-2009, China's cumulative trade surplus with the U.S. was nearly $2.1 trillion. This is the vast bulk of the $2.4 trillion in Chinese reserves. China cannot spend those dollars at home and must find another outlet. There is not nearly enough gold, iron, or even oil to buy -- some money must go back into American bond and stock markets, the only ones in the world big enough to absorb China's trade earnings.

This is the true nature of the Sino-American economic relationship: the world's second-most important economy, and the world's first.

Derek Scissors is a research fellow at the Heritage Foundation. This article draws from "10 China Myths for a New Decade" published by the Heritage Foundation.